6 U.S.-Based Picks for the Global Economy

By Edward J. Roche

One of the current great debates is whether or not the slow down in the US economy will torpedo growth in ex-US economies. Most analysts tend to take an all or nothing view. One camp says that economic growth in countries outside the US is bound to disappear given the sharp US decline. The other camp contends that strong growth in places like Asia will continue on unabated.

Of course the more likely outcome is that something in between will occur. The US slow down along with the lower dollar will take away some sales from ex-US companies with large markets in the US. For US based companies with markets outside the US, the low dollar represents an opportunity There is also a large and growing amount of worldwide trade that does not directly involve the US. For example imports from China to Europe increased from 75 billion Euros in 2000 to over 195 billion Euros in 2006.

On an overall basis the new world economy is much more diverse and dynamic than it used to be. The number of regions with new wealth and a growing consumer class has seen unprecedented growth. This new diversity and dynamism is very healthy and should clearly act to buffer any monolithic worldwide slow-down.

Another current investing myth is that mid and smallcap US-based companies are poor investment choices in the new worldwide economic environment. The rationale put forth for this argument is that mid and small cap US have a low proportion of revenue outside the US. The myth is that they do not have the understanding of ex-US markets or the capabilities to exploit them. On the contrary I am finding that many mid and small sized US based companies are doing very well outside the US.

My long term investment preference is for smaller companies that have the opportunity for large future growth. I have been finding a number of great US based companies with market caps under $5 billion that have a large and growing proportion of revenues from outside the US. These companies are finding the markets, developing products and services for those markets, and they are navigating the regulatory and cultural issues to succeed outside the US. Here is a list of some of these dynamos:

• Harsco (HSC) – a provider of services to the steel, construction and railway industries derives 70% of its revenues from ex-US countries.
• Watson Wyatt Worldwide (WW) – a provider of benefits and financial counseling services has offices in 32 countries. Over 40% of sales come from outside the US.
• Jones Lang LaSalle (JLL) gets over 72% of its real estate management and investment services from outside the US.
• Trico Marine (TRMA) derived 74% of 2007 revenues from international operations and has key strategies to expand this. The company is also seeing great recent benefits from more favorable Norwegian tax treatment.
• Woodward Governor (WGOV), the turbine and power company has 52% of sales from ex-US sources.
• Atrion (ATRI) a producer of medical products increased ex-US sales from 30 to 36 % going from 2006 to 2007.

The new globalism challenges companies to compete on a worldwide stage. Many small and mid-sized US companies are stepping up to the challenge. We also think that with the lower dollar these types of companies could be attractive take-over targets in the coming months.

The Author's Disclosure: We own shares in all of the above companies in managed accounts at Freedom Mountain Investments.

The financial market of 2013

By Martin Hutchinson - he is the author of "Great Conservatives" (Academica Press, 2005). Details of the book can be found on the Web site http://www.greatconservatives.com/.


The Bear Stearns bailout was not quite unprecedented; Continental Illinois Bank in 1984 and Citicorp in 1991 were both beneficiaries of Fed-orchestrated rescue operations. And notoriously, the hedge fund Long Term Capital Management was not allowed to fail in 1998. However since the mortgage crisis is by no means over, and further financial difficulties seem likely to appear as the US recession deepens, it raises the interesting question of what kind of US financial system we can expect to see in 2013, after the storm has passed.

Economically, we can expect to be climbing out of the current unpleasantness by 2013 -- it may be prolonged, but probably not quite that prolonged. This is not Japan, and given the choice of a short sharp shock or 15 years of stagnation, most US voters would choose the short sharp shock. In any case, capital spending has been depressed since 2001 and corporate balance sheets have markedly improved; thus we are to some extent already seven years into the process of recovering from the dot-com bubble. Nevertheless, the financial system in 2013 will have a memory of a debt crisis, followed by a sharp decline in housing prices, followed by inflation, followed by a decline in stock prices,. It will not have been a pleasant five years, and financial market participants, both institutional and individual will have been scarred by the experience.

Financial market structure in 2013 will probably be very different from today. How different depends on the degree of pain suffered by market participants in the intervening five years, and the actions taken by the authorities in their attempts to clean up the mess and return markets to an even keel. Those matters are intrinsically unknowable; while one can forecast with some assurance the general shape of an economic downturn, one cannot be sure of its depth, nor of the order in which traumas occur, nor of the political position, economic resources and sheer basic competence of the authorities attempting to deal with problems.

It is just possible that the impending downturn will be relatively mild, in which case the financial market structure and ethos will be only modestly changed, as it was by the 2001-02 downturn. That outcome is however fairly unlikely given the apparent scale of impending losses. In what follows I have assumed that serious and repeated losses will have provided Teaching Moments for market participants and regulators, and will have pushed the market structure beyond the “tipping point” at which fundamental change occurs and a new equilibrium structure shakes itself out.

In that event, of a recession and financial crisis that takes Wall Street beyond the “tipping point” at which a new structure appears, the risk-tolerant, even risk-seeking culture prevalent on Wall Street for the last generation will be gone. In addition, government will have stepped in with new regulations, some of which like the Glass-Steagall Act of 1933 that separated banking and investment banking, will decades later prove to have been counterproductive.

In all probability the most structurally significant of those regulations will involve the “too big to fail” doctrine that has repeatedly brought the Fed to rescue of ailing behemoth banks and investment banks. If an institution is too big to fail, so that taxpayers are ultimately at risk for its actions, then well designed legislation would also prevent it from taking excessive risks. The ludicrous structure of the – hopefully now moribund -- Basel II bank capital regulations allowed large banks to take more risks than small ones, while relying on their own dodgy risk management systems to monitor the mess. The huge checks that taxpayers will be forced to write in the downturn will bring huge political demands for legislation forcing “too big to fail” banks and brokers to act in a highly conservative manner in order to preserve their “too big to fail” status.

Under this new legislation, banks and brokers with more than a certain volume of deposits, capital or total assets will be compelled to register as “mega-institutions.” They will benefit from an automatic Fed bailout, but in return will be compelled to submit to very strict capital ratios and restrictions on the businesses they will be permitted to carry out. In particular, they will be permitted to carry out new businesses to a total principal amount of only 10% of their assets, until those businesses have been registered with and approved by the Fed for mega-institution activity. Thus credit derivatives, for example, would not have been a permissible business for mega-institutions except in small amounts until the Fed on behalf of the public was completely satisfied their risk management problems had been solved.

With these restrictions, the mega-institutions would be neither risk-seeking nor innovative. They would be conservative in outlook, and their management would be paid respectably but not lavishly, perhaps somewhat above the level of Federal civil servants of equivalent responsibility. Fannie Mae and Freddie Mac, which by 2013 will probably have received at least one taxpayer bailout, will be registered as mega-institutions, and compelled to follow the stringent capital regulations for “too big to fail” banks. (If this put them out of business, tough; the home mortgage market would be the better if it lacked their quasi-public participation). In that event they would probably pay their top brass like the GS-15 civil servants they truly are.

Given the draconian restrictions on mega-institutions, new financial innovations would have to come from somewhere else, as would the risk-seeking that has been so successful in the last couple of decades. In the latter area, current structures would probably survive, to a limited extent, in hedge funds and private equity funds. These would have difficulty raising large amounts of capital, since the mega-institutions would not be allowed to invest in them, and would be very limited in their lending. Moreover fiduciaries such as pension funds will by 2013 have discovered the hard way the legal dangers of subjecting beneficiaries’ money to the risks of hedge fund investment and the Pharaonic remuneration standards of hedge fund managers.

As at present, hedge funds and private equity funds would be short-term in their orientation, and would continue to supply capital to the riskier areas of arbitrage and venture capital and psychic and occasionally financial satisfaction to the greedier “bankers.” Their area of productive operation might theoretically be increased by removing the competition from the mega–institutions, but their profitability would alas be severely affected by this elimination of a class of enormously rich suckers.

There would then remain a need for intelligence, to carry out true financial innovation, profit from new product areas while their volume is still relatively small and their margins high and advise on merger and acquisition transactions and on financial re-organizations generally. This business would be increased by the elimination of many large “profit center” finance departments in major corporations. The losses and indeed bankruptcies due to ill-judged speculation by profit center finance departments will have demonstrated to even the doziest Boards of Directors that at best such departments are an expensive, poor quality and unnecessary duplications of Wall Street, while at worst they are an invitation to ignore the firm’s core business and “make the numbers” through value-subtracting speculation. Eddie Lampert, he of the attempt to turn Sears Roebuck into a hedge fund, will no longer be a revered name by this point.

This intelligence will be provided by much smaller houses, generally private partnerships, living on their wits rather than their capital, which will navigate between the hedge funds and mega-institutions to make money for themselves and provide service to their corporate and wealthy individual clientele (private banking is an intellectual-value-added business only at the very top of the wealth spectrum.) They will perform the functions of the pre-1986 London merchant banks or some of the pre-1975 Wall Street investment banks, and will operate in the same way, living primarily on the fees they earn. By removing the temptation to “principal investing” inherent in the current behemoths, these institutions will eliminate a huge conflict of interest and allow for the reduction in the share of national income devoted to financial services. Naturally, to deal effectively with giant corporations and the very rich they will have to have what the 1960s Bank of England Governor Rowland, Lord Cromer called “prestige and standing.” As their market develops they will quickly discover that they will not get this by operating hedge funds, or by risking scarce capital in speculation.

Finally, there will be the “minnows,” those banks and brokerage houses not large enough to be “mega-institutions” but still providing banking and/or brokerage services to a limited clientele, generally regionally. They will not be permitted to grow beyond a certain point without registering as “mega-institutions” but will otherwise operate with fewer restrictions and more generous capital ratios than the mega-institution fraternity. Since regulation will have eliminated much of the economies of scale from growing “too big to fail” these entities will be highly competitive in their limited markets, surviving by means of lower capital costs, lower top management salaries and better customer service. Indeed, since securitization will have fallen largely out of favor, they may find a profitable new line of business in home mortgage lending, which they will perform more efficiently than the Wall Street machine. (Research has shown that the move from direct home mortgage lending to securitization between 1970-75 and 2000-05 added about 50 basis points per annum (0.50%) to the cost of every home mortgage in the United States – the new market was pure rent seeking.)

The new Wall Street will be less exciting for the greedy, but provide a better service for customers, while shrinking the financial services sector back towards its historic level and eliminating most rent seeking behavior. As such, its emergence will be one of the few unequivocal benefits of the miserable recession ahead.

Gold Stocks Comparison Table

(in $millions except per share numbers)

Source: Company reports and Yahoo! Finance.

Note: "YTD" is "Year-to-Date"; "Rev" is "Revenue"; "N/M" is "Not Meaningful"; "Chg" is "Change"; "Net Margin" is for last 12 months.

Who's Minding the Minders of Chinese Accounting?

By LESLIE P. NORTON (from Baron's 2/18 issue)

INVESTORS WHO BUY THE U.S.-listed shares of small Chinese companies depend on financial auditors to offer independent and expert oversight of their corporate statements. These investors also rely on the Public Company Accounting Oversight Board (PCAOB), the quasi-government agency created by the U.S. to supervise the country's auditors after the Enron and other accounting scandals that occurred early this decade.

Yet red flags from this hot, fast-growing slice of the stock market often seem to go unmentioned by U.S. auditors and regulators.

We previously raised the issue of auditor independence in a story about American Dairy (ticker: ADY), a Chinese milk-powder company that jolted shareholders in December by saying it had dismissed its independent accounting firm, withdrawn its 2007 revenue and profit guidance, and was the subject of an informal Securities & Exchange Commission probe ("Curdled Expectations1," Dec. 17, 2007). American Dairy's independent U.S. accountant, Murrell Hall McIntosh, was working with a Hong Kong auditor, Henny Wee, who, it turned out, was a principal in Belmont Capital Group, a firm that provided capital-raising and consulting services to American Dairy before its public listing. The SEC is investigating whether Wee was truly independent. After our story, the company's shares collapsed and ADY since has hired Grant Thornton as its independent auditor.

Auditors and regulators aren't doing all they should to protect investors from problems at U.S.-listed Chinese companies.

But American Dairy is just one of 170 small Chinese companies that have come public in the U.S. since 2000 via a "reverse merger." In these transactions a privately held Chinese company hooks up with a shell company that has a U.S. listing. This way the Chinese outfit avoids much of the time, expense and regulatory scrutiny that comes with a traditional initial public offering.
The same U.S. auditor, Murrell Hall, was also working with Wee when he introduced OraLabs, a shell company, to Belmont, which then introduced it to China Precision Steel (CPSL). The meetings, described in proxy filings, took place in December 2005 -- long after the date Wee told the SEC he ended his business ties with Belmont. Belmont signed a consulting agreement with China Precision, and was paid with shares ultimately representing 11% of the company.

This pattern "shares many similarities" with the relationship among American Dairy, Murrell Hall, Wee and Belmont, says Todd Fernandez, senior research analyst at proxy-research firm Glass Lewis, and "raises serious questions about auditor independence." Wee and Murrell Hall didn't respond to requests for comment. Tracy Hung Wan, CEO of Belmont, referred Barron's to proxy filings with the SEC. The SEC and China Precision wouldn't comment.

There are many reasons accounting problems seem rife in Chinese companies. Kenneth Banet, the partner overseeing Grant Thornton's China practice, explains that Chinese reporting is tax-oriented, and companies don't report sales until customers pay their bills because sales tax is due immediately on receivables. Companies frequently underreport sales and profit to avoid being on the hook for taxes they haven't received. They also often borrow from related-party companies without repaying. (These related parties are common in China because laws limit the kinds of businesses single companies may conduct.) But to list in the U.S., a company must bring its numbers into compliance with U.S. accounting principles and correct any misreporting before an independent auditor signs off on the statements.

Audits of Chinese reverse mergers are even more complicated. For one thing, the Chinese partners usually are opaque, with ownership structured through British Virgin Islands holding companies. The SEC doesn't scrutinize reverse mergers, until the new company raises funds. As a result, investors depend heavily on those in a position of oversight -- such as auditors.
The way advisers are paid in reverse mergers can pose conflicts for supposedly independent auditors. Peter Humphrey, founder of Beijing-based ChinaWhys, which helps multinationals investigate potential fraud in their Asian operations, says that consultants helping Chinese entities list through a reverse merger are often compensated with up to 15% of the stock of the new public company. "The auditors, who are paid by the lead consultants, at least indirectly become stakeholders. In some cases they may even receive actual shares," Humphrey says.
In China, U.S. auditors frequently use contractors to review corporate financials, which also can cause problems. The PCAOB periodically inspects auditors. Mark West, the board's regional associate director, says "inspection teams [have] reported several deficiencies regarding the use of other auditors, including firms reporting on the financial statements as principal auditor when their participation was not sufficient to enable them to serve in that capacity."

All of these shortcomings can lead to more restatements. Puda Coal (PUDC), for instance, said it "mistakenly" overstated 2007 revenue guidance by 34% and net income guidance by 59%, but didn't realize it for more than six months. And China BAK Battery's shares have lost more than half their value after it restated three years of financials in 2006.

The PCAOB's database can help identify problems. One auditor of Chinese companies like China Clean Energy (CCGY) and China Kangtai Cactus Biotech (CKGT) is Michael T. Studer of Freeport, N.Y. In 2006, during an inspection, the PCAOB found "deficiencies of such significance that it appeared...the Firm (Studer) did not obtain sufficient competent evidential matter to support its opinion on the issuer's financial statements." Moreover, in 2004, the National Association of Securities Dealers expelled Studer's firm and barred him from association with any securities firm.

A spokesman for Studer said the firm "will of course comply with any directives" from the PCAOB. He added the NASD bar did not involve any accounting or auditing matters and is on appeal in federal court.

The Bottom Line:
Beware of Chinese companies coming public in the U.S. via reverse mergers. Their accounting can be murky, financial restatements are rising and conflicts of interest abound.

Sky One Medical (CSKI) and China Education Alliance (CEUA) hired auditors at Sherb & Co., in Boca Raton, Fla. PCAOB's database has a June 2007 entry reporting "deficiencies" in an inspection of Sherb. The auditor's registration file also includes a letter in which Sherb asks the PCAOB not to deny its registration based on a pending securities class-action lawsuit that accused Sherb of signing off on alleged revenue fabrication by a Boca Raton-based financial-services company.

Christopher Valleau, who runs Sherb's China practice, says the PCAOB inspection found a single audit deficiency that didn't pertain to a Chinese client, and that it "is not uncommon or unusual for any quality firm that audits public companies to have at least one comment from PCAOB staff." Sherb has made partners more responsible for any problems, he says, and improved education. The class-action suit, he adds, was settled "without any finding of fault against our firm" and never went to trial.

As for Murrell Hall's recent decision to stop auditing Chinese reverse mergers, Valleau say it's a non-event. "If Ernst & Young left, it would impact the landscape. But not Murrell Hall, and not us. There are plenty of firms out there doing what we do."

Learn Economics from Blogs

Economics Blog Directory & Ranking - an excellent source of economics blog. I especialy like the Mankiw's, Freakonomics, and the Austrian Economists'. Interested? Here's an excerpt from Freakonomics' 03/21 blog post on "Niceomics", share your thoughts here after reading is quite welcome. :-)

"People who punish others the least earn the biggest rewards in repeated interactions, according to a new study published in the journal Nature and authored by Martin Nowak, director of the evolutionary dynamics lab at Harvard University.

At the same time, we are happiest when we’re spending money on others instead of on ourselves, says another team of researchers out of the University of British Columbia and Harvard Business School.

Has the “nice guys finish last” theory finally been put to rest? ..."

S&P 500 volatility at 70-year high

Note this is backdated on 3/19. The volatility surely has changed downward during the past week.

NEW YORK, March 19 (Reuters) - Volatility in the Standard & Poor's 500 stock index .SPX, the most widely-used barometer of the U.S. stock market, is at a 70-year high, according to an analysis released on Wednesday by Standard & Poor's.

Measured by daily changes of at least 1 percent in the index, volatility has soared since credit concerns became a critical issue in the summer of 2007, S&P said.

The number of significant daily market moves was 12.9 percent in the first half of 2007, but rose to 38.6 percent in the second half of last year as concerns grew. The number of such daily moves has increased to 51.9 percent in 2008, a level not seen since 1938, S&P said.

The review by Howard Silverblatt, S&P's senior index analyst, said that the upcoming quarterly earnings season is likely to add to the volatility. Silverblatt said earnings estimates are unusually wide considering how close it is to the start of the earnings period.

With estimates far apart, "there are going to be a significant number of surprises out there, which will translate into additional buying and selling pressure," he said. (Reporting by Cal Mankowski; Editing by Chizu Nomiyama)

Profitability Ranking of NASDAQ-100 Stocks (Updated 10/4/2007)

In this blog I intend to collect some resources on the financial market for (1) investors, (2) observers who view the market as a place mirroring human nature and thus practice tao (or zen, or whatever you call it), and (3) learners to grow to be an experienced investor and/or practicer of tao/zen.

This is my very first post in this blog, and I would like sharing the resources discovered with all visitors to my place. Here is the first one:
http://www.nasd100.com/net/index.html